By Brett Shadbolt on Tuesday, 06 March 2012
Category: Articles

Transfer pricing for intangibles: Risk & Opportunities

Transfer pricing refers to the way that multinationals price all transactions (goods, services, royalties, interest etc.) between related entities.  Transfer pricing is a primary concern for tax authorities that want a fair share of tax revenue and for multinationals that want a true measure of their profit driving activities. Such transactions need to be priced on an “arm’s length” basis and multinational taxpayers are faced with significant compliance obligations and penalties to ensure compliance with this principle.

Since 60-80% of the value of an MNC is considered to lie in its intangible assets, it is no surprise that the OECD and tax authorities globally are now particularly focused on this aspect of transfer pricing.  The potential risks can include disallowance of tax deductions for license fee/royalty payments paid to related parties, arguments for significant exit taxes where intangibles are moved between group entities and claims for increased profitability in local distributors due to the presence of local marketing intangibles.

As an indication of what impact this can have, the largest transfer pricing adjustment in history was imposed by the US Internal Revenue Service on pharmaceutical company GlaxoSmithKline.  In this case, there was a dispute between the IRS and HMRC in the UK regarding whether the product intangibles or the marketing intangibles were the key driver of the success and profitability of a particular drug.  Such differences of opinion are one of the many challenges of transfer pricing for intangibles and will be a critical feature of transfer pricing disputes going forward.

So what do multinationals need to do to ensure these risks are effectively managed?  For a start, they should:

• Review royalties and license fees for product, process or marketing intangibles to ensure there is a clear benefit received from the payment and that the rate applied can be demonstrated to be arm’s length if and when questioned by one of the affected tax authorities;

• When designing or reviewing a transfer pricing system, give particular attention to where the key intangible-generating activities are located, as these may give rise to higher profit expectations in future; and

• Consider the impact of the transfer pricing rules and potential exit taxes when undertaking any form of business restructuring involving movement of functions or assets within a group.

Finally, and most importantly, this focus on intangibles also represents an opportunity for taxpayers to identify what their intangibles are, where they are located and whether they can be managed more efficiently and effectively from an operational perspective in a centralised business model.  A further motivation is that centralising the ownership and management of intangible assets in a low tax jurisdiction, such as Hong Kong or Singapore, where this is supported by genuine economic substance and decision-making, may enable a multinational group to achieve significant reductions in effective tax rates while better managing overall transfer pricing risk.

 
Steven Carey is TPA Global Partner Asia